Large-market caps are the next target for direct lenders, which have already carved out an almost 50% share in mid-market leveraged lending in both the U.K. and Germany.

The nature of terms, pricing, and ease of access still mean most sponsors will favor the syndicated loan or high-yield markets in most instances, but direct lending — debt provided by private investment funds raised from institutional investors rather than traditional bank arranged loans — has become a more mainstream alternative, with an increasing number of buyout firms now open to it.

Numbers are driving the trend. For the direct lenders, as a strategy, lending is most profitable on a large scale. Building a skilled team to originate deals, manage a portfolio, and deal with any problems is expensive. And the costs are similar whether a team does two deals or ten, said sources.

Private debt has proved its ability to raise capital from investors, but that capital must be deployed to earn the management fees that pay for office space, staff, and all the other upfront costs of running the fund.

Combined with this, for the alternative asset managers that are so often behind private debt ventures, the business must generate profit because both the management fees and potential carry from credit are much lower than what partners earn from a successful buyout strategy.

Scaling up at a fearsome rate

Europe's largest direct lenders have scaled up with multibillion euro funds and a pool of investors willing to write additional checks on top of their pooled fund commitments to back large-ticket individual deals. With several billion euros in the pot, there's a lot of pressure to deploy that capital. Large deals are simply the most efficient way to earn the management fee.

Naturally, both the high-yield and syndicated loan markets are paying more attention than ever to direct lenders as they raise and deploy capital at a fearsome rate.

On the flipside, for borrowers, the key number is 6.5%. This is because the 90-day rolling average new-issue yield for a single-B high-yield offering was 6.5% as of Sept. 21, according to LCD, which is broadly in line with unitranche pricing.

The high-yield market should, by now, be used to losing out to direct lenders, said one market participant, as the trickle of storied credits turned from the bond market to direct lenders became a clear stream in 2017.

The trickle began with deals that were large direct loans, namely, GSO / Blackstone Debt Funds Management LLC's £250 million unitranche backing Bain Capital LPs buyout of Ibstock Brick Ltd from Irish builder CRH PLC in 2014, the $400 million-plus direct lending club financing for the acquisition of Theorem Clinical Research by Chiltern, and the still record-breaking $625 million unitranche financing from GSO backing the merger of specialty chemical companies Polynt SpA and Reichhold.

What's more, direct lenders last year scooped up several deals that had been expected to hit the high-yield market, including Soho House, which tapped Permira Holdings Ltd. for a unitranche rather than refinance its bonds, and Zenith, the fleet management and leasing firm that brought its bond arrangers into the unitranche deal set up by GSO. And the trend has continued this year.

HSS Hire signed a £220 million term loan provided by HPS Investment Partners LLC to refinance debt, including the London-listed firm's secured notes that were due to mature in August next year.
Market sources said more than one potential high-yield issuer has ended up in the arms of a direct lender this year, and with even more favorable pricing and terms than it would have likely seen from the bond market.

And with more direct lenders bending their return requirements to do more stretch-senior deals with margins of E+550 or thereabouts, there is a clear argument in favor of direct lenders over even the cheaper syndicated loan market for some borrowers.

For instance, David Lloyd has repaid its £260 million, dual-currency TLB and £120 million second-lien facility with proceeds from a substantial unitranche provided by The Children's Investment Trust, sources said.

In February, sponsor Waterland pulled the €176 million term loan backing the carve-out of Combell Group and merger with Zitcom in favor of a planned private debt financing. The TLB had launched to general syndication in January.

The syndicated deal was not rated and was guided at launch to pay E+400 with a 0% floor, offered at 99.5. A €32.5 million revolver rounded out the deal, to bring the total financing to €208 million.

Sources said at the time that the change in tack was designed to give the new company more flexibility as it pursues an ambitious acquisition strategy. Waterland carved web-hosting company Combell out from portfolio firm Intelligent and merged it with Zitcom, a Danish asset it agreed to buy in mid-2017.

Flexibility is the key promise that appears to be winning over borrowers that would otherwise be sure customers for a syndicated loan. With plenty of dry powder, more direct lenders are comfortable with committed acquisition lines — particularly when the borrower has a clear buy-and-build strategy, often with targets already identified as the initial financing is put in place. Previously, direct lenders avoided committed, but undrawn lines as these tied up their assets without earning them a management fee. There's been a sea-change in their approach however, with some even beginning to offer revolving credit.

The case of Envirotainer was different. Here, market sources say the syndicated market was set to push back on the starting net leverage of 7.75x. So Goldman Sachs Group Inc., which was already lined-up to provide the second-lien loan financing, stepped in and provided all of the term debt. Cinven agreed to buy biopharma freight specialist Envirotainer from AAC Capital Partners in July, in a deal said to value the firm at more than €1 billion.

What does this mean for fixed income?

This is bad news for fixed-income bankers already struggling to generate the same fees their businesses used to command. The fact that direct lenders nearly always demand a maintenance covenant versus the over 80% cov-lite loan market and practically covenant-less high-yield market, is one advantage that those markets can still claim.

But how long can that continue? Cinven Partners LLP opted for a unitranche to back its acquisition of JLA this year. The financing was cheaper than the blended yield on the senior and junior loan underwrite that was offered, and did not include a springing maintenance covenant, sources said, beating the traditional large-cap financing markets on both price and terms.
Loan and bond bankers are presumably making the arguments against relying on a sole lender — particularly a relatively unproven one that may have different priorities when it comes time to refinance.

This is potentially the strongest argument against which direct lenders must defend themselves.

Many of them have not been proven through the credit cycle. And while they may have billions to invest, their portfolios are less diversified than those investing smaller tickets in a broader range of syndicated loans or high-yield bonds.

Should even one large direct lending deal go sour, it could potentially cripple the lender.
In the meantime, the promise of swift, confidential, and favorable financing terms will continue to tempt large-cap borrowers.

LCD is an offering of S&P Global Market Intelligence.